The Pensions Regulator has issued a guidance statement for trustees of UK occupational pension schemes on the use of LDI in which it calls on trustees to maintain an appropriate level of resilience in leveraged arrangements to better withstand a fast and significant rise in bond yields. The statement also calls on trustees investing in leveraged LDI to improve their scheme's operational governance.
The Regulator has also welcomed coordinated statements made by the Central Bank of Ireland (CBI - Ireland) and the Commission de Surveillance du Secteur Financier (CSSF - Luxembourg) on the resilience of LDI funds in which they set out their expectations for the level of the buffer that should be retained within such funds.
As the Pensions Regulator's statement sets out, the turbulence in longer-dated UK government debt in late September exposed shortcomings in the resilience of leveraged LDI funds, as well as in the operational processes of the funds and of pension schemes investing in them. In particular, the ability to raise liquidity in a timely manner. This created risks for pension schemes of losing the effectiveness of their hedge during a period of high volatility. It also created the potential for wider impacts on the orderly functioning of the economy.
Consequently, the Regulator wants to ensure that pension schemes and asset managers have taken steps to enhance the resilience of their leveraged LDI funds and that this resilience is maintained. It is also keen to ensure that trustees learn the lessons from recent events and take steps to improve their operational governance arrangements to ensure they are better able to respond to future crisis, where swift action needs to be taken.
Levels of resilience
The statements from CBI - Ireland and CSSF - Luxembourg recognise that the resilience of GBP LDI Funds across Europe has improved significantly since the events of early Autumn, with an average Yield Buffer in the region of 300-400 basis points being built up. However, the Irish and Luxembourg regulators make clear that they expect these levels of resilience and the reduced risk profile of GBP LDI Funds to be maintained, given the market outlook, and they do not consider any reduction in the resilience at individual sub-fund level to be appropriate at this time.
The UK Pension Regulator's statement supports these calls and makes clear that the same level of resilience should be maintained across pooled and segregated leveraged LDI mandates and also single-client funds. If a scheme is not able to hold sufficient liquidity, or is unwilling to commit to that level of liquidity, the Regulator expects the scheme's trustees to consider their level of hedging with their advisers to ensure they have the right balance of funding, hedging and liquidity.
Where a scheme or asset manager considers that it might be necessary or appropriate to reduce an individual GBP LDI Fund's resilience below the levels set out above, the Irish and Luxembourg regulators have made clear that they should:
- Inform the authority supervising the relevant investment fund manager and, in case of cross-border setups, the authority in the country where the LDI Funds are domiciled, of the proposal to reduce an individual GBP LDI Fund's resilience and of the level; and
- Complete the following actions prior to making any reductions
(with such documents to be made available to the relevant
authorities upon request):
- undertake and document a detailed analysis justifying the need to reduce the GBP LDI Fund's current resilience;
- complete and document a risk assessment with relevant modelling of how the proposed reduction in the GBP LDI Fund's resilience will not impact the orderly functioning of the GBP LDI Fund in the current and in stressed environments; and
- detail and document a step-by-step plan for returning the GBP LDI Fund to current levels of resilience in the event of increased market volatility, noting any assumptions that the framework is based on.
The fund or asset manager must also ensure clear policies and procedures are established to increase resilience in the event of further volatility in the market.
Actions for trustees
The Pensions Regulator has made clear it expects trustees to work with their advisers to test the liquidity buffer in their scheme's LDI arrangements. If trustees depart from the level of the liquidity buffer set out by the Irish and Luxembourg regulators, they should:
- work with their advisers to demonstrate the buffer the scheme has in place;
- complete a risk assessment of how the scheme will respond to stressed market events so that the scheme remains resilient during these events, including how it will raise liquidity - taking into account that the ability to sell assets in such conditions may be greatly impaired;
- detail a step-by-step plan for bringing the scheme to higher levels of resilience in the event of volatility returning to the market, noting any assumptions in respect of market conditions, operational arrangements and timescales that the plan is based on; and
- document these arrangements and review regularly.
The Regulator also calls on trustees to review their governance processes and consider the challenges that arose for their pension scheme during the volatility in September and October 2022, and then consider what practical steps in terms of their arrangements (or other governance considerations) they can implement as a result of lessons learned.
The Regulator also recommends that trustees take the following steps (where relevant) to ensure they are able to react quickly in response to future market stress:
- Confirm authorised signatories are up to date and ensure that governance is sufficiently robust, and that decisions can be made at speed in stressed market conditions;
- Stress the non-leveraged LDI asset allocation (eg equities, corporate bonds) using a yield shock as set out by the NCAs;
- Stress the leveraged LDI pooled fund / segregated mandate using the same yield movement;
- Calculate the required collateral amounts, and the type of assets (for example, gilts, cash);
- Specify the dates when these collateral / margin calls need to be made;
- Specify what assets would be sold, when the sell instructions
would need to be given, and when the cash is settled:
- this should take account of the settlement period of the various asset classes or the dealing dates of pooled funds and any potential risk that any fund may defer redemption if they are unable to meet liquidity needs, or become considerably less liquid in such conditions;
- trustees should liaise with LDI fund managers and ask for an assessment of the liquidity of the assets that the schemes intend to use to meet cash requests;
- Confirm who the instructions need to go by and the method of signature (electronic or wet ink);
- Confirm that necessary collateral / cash margins can be paid on the dates specified;
- Confirm the asset allocation post collateral / margin call; and
- Document these arrangements and review them regularly.
The Regulator also recommends that trustees continue to have detailed conversations with LDI managers on liquidity for pooled and segregated LDI arrangements, including:
- what the triggers for replenishment are;
- confirming the process for meeting collateral / margin calls; and
- providing visibility of liquidity to LDI managers as appropriate.
Line of credit from employers
As an alternative to maintaining high levels of investment liquidity within their scheme, the Regulator says that trustees may prefer to establish a line of credit with their sponsoring employer to ensure liquidity. Such arrangements should be documented and reviewed regularly to ensure they remain in place and clearly reference the time period, amounts and conditions. The emphasis should be on immediate flow of cash if required.
However, the Regulator reminds trustees that any such facilities must only be utilised on a short-term basis and for liquidity purposes, so as not to fall foul of the general prohibition against borrowing by pension scheme trustees.
Trustees should also make sure any arrangement is reviewed legally to avoid the risk of an abrupt end to the facility when it is needed.
Don't neglect inflation risk
One issue not covered in the Pensions Regulator's statement but which has been identified as a potential future risk with LDI funds in the recent evidence sessions being held in Parliament is the risk of inflation falling from its current high level and the potential for deflation. When highlighting this risk, Stephen Taylor, of LCP, cautioned that "We need to be aware of how things like LDI are operating in that context as well, particularly as schemes are effectively rebuilding their strategies focusing on this interest rate risk."1
1 See Stephen Taylor's response to Q62 in the 23 November 2022 evidence session before the Work and Pension Committee.
The Pensions Regulator and trustees have come in for criticism of their preparedness for the events of September and October this year. Both will want to avoid a repeat.
As the statements from the Irish and Luxembourg regulators recognise most schemes and asset managers have taken steps to significantly increase the level of resilience within their leveraged LDI funds in light of recent events. However, the Irish, Luxembourg and UK regulators are clearly concerned to ensure that this level of resilience is maintained moving forwards. The Pensions Regulator is also keen to ensure that appropriate lessons are learnt and that trustees of UK pension schemes revise their operational governance arrangements so that they are in a better position to respond to future market turmoil.
As MPs and others continue to scrutinise the events of early Autumn, we can expect to hear more from the Pensions Regulator on the use of LDI in due course. Indeed, the Regulator's statement makes clear that it is continuing to discuss this issue with a number of external stakeholders with a view to providing clear longer-term expectations in this area. A further update is likely to be set out in the Regulator's Annual Funding Statement in April 2023 with further statements and guidance to be published as necessary.
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